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What Is Dollar-Cost Averaging And How Does It Work

Publish Date: 03 Feb 2020

Dollar-cost averaging is a long term investing strategy that does not require experience or huge amounts of money. This technique has been around for decades, and is the most used strategy for long term investors everywhere.

 

Definition of dollar-cost averaging

Dollar-cost averaging is an investment strategy in which an investor spreads the total amount they want to invest across periodic purchases of the target asset. This is an effort to reduce the impact of volatility on the overall purchases.

The purchases of the asset occur at regular intervals regardless of the price at a single point. Simply put, this technique removes the detailed work of trying to time the market, which we all know is almost impossible. It secures your place in the market at the average price of the asset, so if the market experiences high volatility, you are safe from immediate corrections.

While there are some disagreements about the extent to which dollar-cost averaging can reduce market risk, there is a general acceptance of the idea an investor who follows this method will be able to withstand emotional dangers during times of volatility, also will most likely reduce loss of buying power during a bear market.

 

How to invest using dollar-cost averaging

The strategy couldn’t be simpler, just invest the same amount of money in the same asset at regular intervals. Ignore fluctuations in price or mild news stories, only major impact news should make you change your investment, such as political changes or legislation changes.

The number of shares, or fractional shares you buy (if you invest through M1 Finance) will depend on the share price at the time of purchase. When the share price increases your investment will buy less shares, and the opposite if the price goes down.

The fact that you are able to buy more shares at a lower price makes this a very lucrative system. Your average cost per share will be lower than the market average on a rising stock by implementing this technique.

 

Reap the rewards of dollar-cost averaging

As I’ve mentioned, dollar-cost averaging is a long term investment strategy, this is not day trading or spread betting. But it can offer great returns if you have a strong stomach, and you’ve picked a good asset.

In the long run, this is a highly effective way to invest. As you buy more shares when the price is low, you reduce your average cost per share over time. So you are already ahead of the market even if the stock returns to its original price, which we will demonstrate further down.

Dollar-cost averaging is also an attractive technique to new investors. It is low maintenance and it allows the investor to slowly build wealth, even if they are starting with smaller amounts of money.

Dollar-Cost Averaging Graph

 

 

If you are a new investor who wants to get started, but doesn’t have a lot of start-up money M1 Finance or Trading 212 is perfect for you. They are both 100% free brokers that allow you to start investing from just $100. This is possible because they utilise fractional shares.

You can calculate your return using a simple equation. Assuming you invest the same amount of money each time, the return from dollar-cost averaging on the total money you’ve invested is:

Dollar-Cost Averaging Equation

 

Where Pf is the current share price of the asset and Pp is the Harmonic Mean of your shares (or average share price). You are calculating a return on your investment as a percentage.

Here's an example of the calculation:

Dollar Cost Averaging return

 

How does dollar-cost averaging perform in the market?

It’s a lot easier to visualise how your money will be invested if I go through and cover a couple of examples.

For ease of calculation I will be using $100 as the recurring investment, but you can start this strategy with $1 if you wanted. Over a 12 month period I invest $100 per month into an index fund with a starting share price of $10.

 

Bull Market

Bull Market Dollar-cost Averaging Example

As you buy shares at regular intervals you protect yourself from slight dips in price. Yes, in this example you would have made more profit from a lump sum investment in month 1. But lets not forget, the market could have just as easily went down.

 

Bear Market

Bear Market Dollar-cost Averaging Example

As I mentioned, the market can just as easily go down. By spreading your investments over a longer period of time you have shielded yourself from a sudden drop in price. The same amount of money has been invested, but your average share price is lower, hence you haven't lost as much as the market.

 

Volatile Stagnant Market

This example is more realistic as the market can go up, then down, then back to its original price, all in one year.

Stagnant Market Dollar-cost Averaging example

As you have invested in the market average price for your shares, you have actually come out on top. The market returned to its initial price, only after dropping below $20 and above. But because the price decreased more than it increased, you are left with a small profit because you took advantage of the market average.

 

Drawbacks to dollar-cost averaging

There are two drawbacks to dollar-cost averaging, but they are very much avoidable.

The first is the fact that executing lots of regular trades adds to trading cost. This is the easiest to solve. M1 Finance and Trading 212 are both 100% free, no commission, no trading fees. However if you prefer to use a high street broker don’t worry. If you are investing with a long term goal, fees and commission will become a very small expense on your overall portfolio.

Second, by dollar-cost averaging, you may lose out on gains you would make by investing a lump sum at one go. Like I’ve mentioned thousands of times, you can’t time the market, so if you invest a lump sum in a stock and the share price dramatically increases you are lucky. But this is not always the case.

What if you invest your entire savings and a huge market correction occurs, you will have lost a reasonable chunk of your portfolio. This is the other side of investing, yes you might lose out on potential gains but, by dollar-cost averaging, you are protecting yourself against potential losses.

 

My long term strategy

Regardless of the sum of money you have, you can start investing using dollar-cost averaging. But it has to be a long term plan, this is not a pump and dump.

While the markets are in constant flux, over long periods of time most stocks tend to move in the same general direction. This is because they are swept along by larger currents in the economy. Because of this, it reduces the value dollar-cost averaging has as a short term plan.

 

My dollar-cost averaging plan for 2020

I’ve been investing using the strategy for over 5 years and have accrued quite a reasonable portfolio. But with the new year of 2020 I’m going to start an account from scratch. I’m still doing my research at the moment, but as of March, using M1 Finance, I will be investing £100 per month (because I’m from the UK) into a diverse portfolio, just to show how good dollar-cost averaging is.

You can follow my 2020 investing journey on my YouTube Channel.

Why such a small amount of money you ask? Because I want to show people that even with a small investment, you can make a difference to your future.

Through good and bad times, I will be investing my £100. You will be able to see my thought process about picking a stock or fund, the price I’m buying at, and a monthly breakdown of earnings (or losses, I’m not perfect).

 

How you can start to invest using dollar-cost averaging

There are more than one way to invest using dollar-cost averaging. The easiest of ways is to get either a 401(k) or Roth IRA, if you’re not sure what any of these are check our article about them. The only problem with these methods are cost, they generally come with commission fees, and fund entry fees. But they are 100% passive and you don’t have to do anything once they are set up.

If you have a more hands on approach but aren’t sure about online brokers, you could instruct a broker to place your regular trades for you. This is by far the most expensive option as traditional brokers charge enormous fees just to place trades, and you normally have to put down a retainer just to get a meeting.

The final method is to roll up your sleeves and go it alone, well not entirely alone, the internet is always there if you need guidance or tips. If I’ve mentioned them before, I’ve mentioned them a thousand times, M1 Finance is the best commission free broker on the market. You can see what I mean in my other article Webull vs eToro vs M1 Finance: Commission Free Brokers.

On M1 Finance you can start from $100/£100, utilise the education centre, check out what the top investors are doing, and set up multiple accounts with automatic allocation when depositing recurring amounts of money.

Take your time when making this decision, if you’re a complete beginner, here are some resources you can use to develop your approach to dollar-cost averaging:

 

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